If you asked the average investor about ETFs twenty years ago, there’s a good chance you would have gotten a blank stare. Fast forward to today, and most investors not only know what ETFs are, but likely own one. Low-cost, transparent and tax-efficient vehicles tend to grow into the mainstream, despite the best efforts of a historically lethargic industry to hide them.
Today, the 351 ETF exchange seems to be gaining real traction and giving investors the opportunity to switch to the ETF structure to enjoy the potential benefits of ETFs. According to Brent Sullivan and Elliot Rozner in Managing concentrated public equity positions by creating an exchange-traded fundin the first quarter of 2026 alone, the amount of AUM seeded through 351 exchanges by individual investors is already over half of what was contributed in the entire year of 2025. This trend is gaining real traction!
A Section 351 exchange allows investors to exchange property for shares of a new company. In the case of a new ETF, which are legally new companies that elect to be treated as a “RIC,” investors are able to exchange their appreciated holdings for shares of a new exchange-traded fund without immediately triggering capital gains. whether rules and tests are respected.
However, many people are wondering what the basis is for using an age-old tax rule and applying it to a modern investment portfolio. More importantly, if 351 swaps can’t be used to diversify highly concentrated positions, why are they being used to house ETFs? We think the answer is simple: investors are gravitating away from sub-optimal investment delivery mechanisms and moving towards the generic benefits that often come with an ETF versus other vehicles: low cost, transparency and tax efficiency. But this is our 40′ view on the matter. We brought in an expert to discuss further…
I invited Brent Sullivan, editor-in-chief at Tax Alpha Insiderhop on over to our YouTube channel to help break down modern tax rule 351 applications. If you’d like to watch our video, I encourage you subscribe to our channel. But in this post, I’ll walk through my three main takeaways from our discussion, along with a few caveats for investors considering seeding ETFs through a 351 exchange (and what tends to get them into trouble).
Let’s begin.
Diversification is key
IRS law is one of the few areas where investors can technically check all the boxes and still fail to comply. The reality is that the IRS doesn’t want you to obey their laws, they want you to SPIRIT of the law. This is what is known as substance over form.
The 351 exchange was designed to help investors start businesses without triggering capital gains when they contributed property to a new business. But in 1960 something interesting happened. According to Brent, “Nearly 200 investors pooled various concentrated holdings and, in essence, traded the single risk for part of a diversified portfolio.”1 Basically they took their concentrated portfolio, performed some tax gymnastics and diversified while neglecting the spirit behind the tax code. Congress did not like this. Eventually, they drew some lines about what portfolios could be contributed to a 351 exchange. In particular, there are two main rules that investors must adhere to if they wish to participate. These are what were called the 25/50 rules:
- The 25% rule states that the largest holding in a contributor’s portfolio must be less than 25% of the contributor’s portfolio.
- The 50% rule states that the five largest holdings must be less than 50% of the contributor’s portfolio.
By establishing these tests, the government emphasized that a 351 cannot be used to diversify a highly concentrated position(1)but also defined what diversification means in a concrete way so that investors have confidence in what “diversification” means from the IRS perspective. Basically, investors who adhere to these diversification rules are considered diversified from the IRS perspective, and while financial experts may think the IRS definition of diversification is inaccurate or wrong, from a legal perspective, their opinions don’t matter.
It seems straightforward. Is there a Gray Area?
While investors must adhere to the 25/50 diversification rules to receive tax-free treatment when contributing to a 351 ETF, there are certain areas where investors can run into trouble. In the paper, Brent discusses many of these tactics, including SATURATION AND sequential planting.
with SATURATIONconcentrated portfolio investors can go out and buy assets just so they can pass the 25/50 test. In doing so, they may run afoul of substance over form and go around the intent of the diversification rules outlined in the law.
with sequential plantinginvestors can start with a concentrated holding, contribute enough to a 351 exchange to pass the 25/50 rules, then use the remainder of the concentrated portfolio along with the newly started ETF to conduct another 351 exchange, and so on and so forth, until the concentrated holding is gone. This is another area where, depending on the facts and circumstances, the IRS may dig a little deeper.
How to avoid gray areas? When contributing to a 351 exchange, investors should ask themselves: Have I followed the intent of the laws? Or I started with a concentrated portfolio and “did a bunch of tricks”2 just to end up with a diversified portfolio? If so, enforcement may drop all the steps and treat it as a major taxable event. However, if investors act within the spirit of the laws, the risk of an enforcement action is very low. Regardless, it’s important for investors to document everything so they’re prepared if enforcement decides to scrutinize their actions.
Education is key
A 351 exchange can seem like a daunting endeavor for individual investors and even advisors. Most are not even aware of the tax code, and some wonder how it can be applied to help determine ETFs. So while this 351 trend is growing, there is still some skepticism preventing it from realizing its full potential. As believers in the power that education3 can play into adoption, which is something we hope will become more common in the coming years.
So we encourage investors to keep learning, ask good and hard questions, and consider the 351 exchange as a legitimate tool in their investment toolbox. By doing so, they can not only help their own situations, but also help spread awareness about the usefulness of the 351 exchange.
- Sullivan, Brent and Rozner, Elliot, Managing Concentrated Public Stock Positions by Seeding an Exchange Traded Fund (March 31, 2026). page 7. ↩︎
- Brent’s words, not mine. ↩︎
- After all, we exist to empower investors through education! ↩︎
References
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Why Exchange 351 Can Revolutionize Investing originally published in Alpha Architect. Please read the Alpha Architect FINDINGS at your convenience.
